Bank profitability, leverage and financial instability: a Minsky-Harrod model

Abstract

This paper develops a stock-flow-consistent macroeconomic model where bank profitability and bank leverage play a crucial role in the determination of firms’ liability structure. The model assumes that banks’ credit supply depends on bank profitability as well as firms’ profit–interest ratio. Our analysis suggests that a strong expansionary effect of bank profitability on credit supply tends to destabilise the economy, leading to cycles driven by the interactions between firms’ and banks’ financial behaviour. The formal framework is used to discuss Hyman Minsky’s proposal in his Stabilizing an Unstable Economy for the control over the permissible leverage ratios and payout ratios of banks.

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